A partnership of four engineers operates a duplex rental business. Five years ag

Question

A partnership of four engineers operates a duplex rental business. Five years ago they purchased a block of duplex, using a MARR of 14% per year. The estimated return at that time for the duplexes was 15% per year, but the investment was considered very risky due to the poor rental business economy in the city and state overall. Nonetheless, the purchase was made with 100% equity financing at a cost of 10% per year. Fortunately, the return has averaged 18% per year over the 5 years. Another purchase opportunity for more duplexes has now presented itself, but a loan at 8% per year would have to be taken to make the investment, (a) If the economy for rental properly has not changed significantly, is there likely to be a tendency to now make the MARR higher than, lower than, or the same as that used previously? Why? (b) What is the recommended way to consider the rental business economy risk now that debt capital would he involved?

Explanation / Answer

(a) The MARR should remain at the same level because the business scenario hasn't changed significantly and so the level of risk continues to be the same.

(b) With the involvement of debt capital, the cost of capital would come down which would make the returns further higher for the equity investors. Although, the pressure of the debt obligation would require the return from the business to be higher than the cost of debt which is not the case in all-equity financing.

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